More on 'overheating' of Indian economy

Raj had asked in his comment on my earlier post what the basis for my optimism about the Indian economy was. Well, there are at least three elements that I (and others) have highlighted:

• The rise in the savings rate from 23% in 2002 to over 32.4% in 2005-06. The investment rate has risen as a result to 33.8%. The increase in higher investment rate translates into an increment in the growth rate.
  
• The turnaround in the manufacturing sector and its improved competitiveness, as a result of which we are seeing rapid growth in manufacturing and not just in services
• Improved export competitiveness which has given us export growth of 20%.

Looking ahead, we can expect savings and investment to rise further. As income levels rise, so do household savings; corporate profitability translates into better corporate savings; better management of public finances improves government savings. Domestic savings will be complemented by foreign inflows in the form of FDI and FII.

You must also factor in higher productivity growth. Increased investment in infrastructure, telecom and IT will also mean higher productivity growth. So will the spread of education. The upside to the Indian growth story is enormous.

But the fact that we are moving towards a distinctly higher growth trajectory- say, around 8.5-9%- does not mean that the economy will not show occasional signs of overheating. In his column in today's BS, Surjit Bhalla dismisses most signs of overheating- the trade deficit, the inflation rate , a boom in credit. He points out that there is no one to one correlation between trade deficit and overheating- the US has a huge trade deficit and a low inflation rate. The average rate inflation rate in 2006, he says, was the same as in 2005- 4.7%. As for the boom in credit, that is only a facet of monetary deepening.

Bhalla then makes the point I made above, namely, that an increase in the investment rate adds to the growth rate- his estimate is of 2.8% being added to the previous trend rate of 5.6%, giving us a minimum growth of 8.4%. Add productivity growth of 1% and you have a growth rate of 9.4%.

Fair enough, but this computation ignores one element. Investment tends to generate output with a lag. The increase in demand takes place first; the increase in output comes later. As a result, we can still have inflationary pressures while we are on our way to a growth rate of 9%. Chairman of the PM's Council of economic advisors, C Rangarajan, makes this point in an interview to BS.

Incidentally, Rangarajan is upbeat about the growth outlook for the current year. He says it won't be less than 8.5% and, more likely, will be 9%. I am happy that, in my own optimism about the growth outlook, I am in exalted company.